Lululemon Athletica Inc (LULU) — Q2 2017 Earnings Call Transcript

Thank you, and good afternoon. Welcome to lululemon's second quarter earnings conference call. Joining me today to discuss our results are Laurent Potdevin, CEO, and Stuart Haselden, COO. Before we begin, I want to remind you that our remarks today will include forward-looking statements that reflect management's current forecast regarding certain aspects of the company's future. These statements are based on current information that we've assessed, but they are dynamic and may change rapidly. Actual results may differ significantly from those implied by these forward-looking statements due to risks and uncertainties related to the company's business. Factors that could lead to these differences are detailed in the company's filings with the SEC, including our Annual Report on Form 10-K and our quarterly reports on Form 10-Q. Any forward-looking statements made during this call are based on assumptions made today, and we do not commit to updating these statements based on new information or future events. During the call, we will present both GAAP and non-GAAP financial measures. A reconciliation of GAAP to non-GAAP measures can be found in our quarterly report on Form 10-Q and today's earnings press release. The press release and quarterly report on Form 10-Q are available in the Investor section of our website, www.lululemon.com. Before we start the call, I want to inform our investors that we are providing a summary of key financial and operating statistics separately on our Investor site for your reference. Today’s call will last for one hour. Now, I would like to turn the call over to Laurent.

Thank you, Howard, and good afternoon, everyone. Our strong Q2 results reflect focused delivery against our key growth initiatives. The strategic pillars, including digital, international, men's and North America drove the improvement in our business as we progress towards realizing our 2020 vision to achieve $4 billion in revenue. We've had some fantastic moments in Q2. We launched category-disrupting product innovation, such as the Enlite Bra; amplified and articulated the brand globally with This Is Yoga, reaching 50 million guests, equally split between men and women; and through powerful community activation, such as Unroll China, we connected directly with guests via live streaming our ambassador-led yoga class to over 150,000 people. As a result, we drove outperformance in Q2, delivering revenue of $581 million, a normalized gross margin of 51.6% and adjusted EPS of $0.39. Our adjusted EPS exceeded our guidance and grew modestly versus last year despite planned digital investment spending. Our comp results were strong across channels and merchandise category. Our performance in Q2 and solid momentum we're seeing in early Q3 gives me great confidence in our strategy and long-term plan. Today, I'll focus on the Q2 results and highlights of the quarter and share our plans for Q3 and the back half of the year. Stuart will review our financials and provide Q3 and full year guidance. We'll then take your questions. As an originator brand, we remain at the forefront of the market we created, powerfully owning our position as the brand that defines an active, mindful lifestyle. In a world of increasingly commoditized guest transactions, our relentless focus on innovation, human connection and our vertical business model allows our guests to enjoy holistic experiences that transcend the 4 walls of a retail store, unlocking tremendous growth opportunity as we reach new guests around the world. From the launch of our first Mindfulosophy meditation lounge in our new store on Fifth Avenue, to the ecosystem of studio, store and community space we created for guests at Queen Street in Toronto, we design into a future of how people want to live their lives and connect with each other. Our laser-focused strategies to retain, inspire and inform guests through an enriched digital experience continues to drive performance. In Q2, we launched our first fully integrated product campaign online and in-store featuring the Enlite Bra. By highlighting its groundbreaking technology, created in our proprietary Ultralu fabric, our most innovative and most premium offering in bras quickly became a top performer, validating the significant potential ahead of us when we deliver category-disruptive innovation to our guests. Toward the end of the quarter, we began our seasonal store retailing, showcasing lightweight jackets and outerwear. Collectively, these campaign strategies have contributed to a 23% increase in traffic year-over-year. In addition and relative to Q1, site conversion has increased by 30%. We continue to make solid strides toward delivering a digital ecosystem that is a seamless extension of our store experiences, founded on human connection and deep product knowledge. Through improved creative photography and video that overtly highlight the innovative performance and functional detailing that defines our product, improved merchandise assortment and technical site enhancements, we are creating a consistently rich and compelling experience for guests. We are early in this journey, and I'm so excited about the tremendous impact our focus has had on the performance so far. As you know, international is a key growth driver for us, and we see great opportunity as guests around the world seek to live more active, mindful lives. Let me start by highlighting our strong performance in Asia. Fueled by strong brand momentum, new-store openings and positive comps both in-store and online, this quarter, we saw 70% year-over-year market growth across Asia, highlighted by our momentum in China that has grown over 350% over Q2 last year. This exceptional growth is partially driven by the outperformance of new-store productivity. Our Tmall business increased 175%, fueled by more than doubling our traffic coupled with higher conversion. Building on the brand's unique positioning to elevate lives through an active, mindful lifestyle, we hosted our second Unroll China event in May. Held across 6 cities with over 10,000 attendees, including 5,000 in Beijing, we shared the power of practice via live streaming yoga classes in Chengdu and Beijing, a concept we'll continue to develop as an extension of the brand's digital ecosystem. We're on track to open 12 stores in Asia this year with 6 stores planned in the second half in China: in Beijing, Guangzhou, Chengdu and Shenzhen. And to broaden our Asian footprint, we are thrilled about opening our third store in Japan later this year in the heart of Shinjuku, following our April opening in Ginza Six and our prior opening in Harajuku. Having recently returned from Europe, while still nascent, it's exciting to watch the wellness trend in cities such as Paris and Munich begin to accelerate with new studios opening and increasing community engagement. Long term, I continue to see meaningful opportunity in the region as we build momentum with market growth over 50% year-over-year. We continue to believe that densification strategies in key cities, supported by a compelling digital ecosystem, is the best path to build strong brand loyalty. In the second half of the year, we're on track to open 2 new stores, including our first store in Munich. In London, where we've built our strongest presence, I experienced firsthand our second annual Sweatlife Festival. This community event brought together 2,500 guests to experience a day of sweat offered by London's top studios while also taking yoga off the mat, through different talks, meditations and personal development sessions. Having personally done back-to-back spinning and boxing, it's safe to say that Londoners are set. Sweatlife is a very effective way to connect with and build our collective, and similar activation will be rolled out in the future. Turning to North America. Before I share updates on Q2, our thoughts are with everyone impacted by Hurricane Harvey. And we are actively supporting our collective in the wake of this devastation. We have 8 stores in the region and have been working closely with colleagues and our communities to ensure the safety and well-being of our people and their loved ones. Returning to our North American performance this quarter. We recently opened destination locations in key market, including New York and Vancouver. In New York, we opened on Fifth Avenue, including our first-ever meditation lounge Mindfulosophy, acting as a destination for visitors from all over the world to escape the city and allow them the space to take a moment to breathe. We're thrilled with the performance so far. It's accretive to our New York store fleet and allows guests from around the world to experience the brand. In Vancouver, we have just reopened our very first store on West 4th in Kitsilano, a beautiful, colocated format that incorporates new technology, innovation and enhanced visual merchandising. Supporting our growing presence and relevance in the run category, we were front and center at the Toronto Waterfront 10K as lead sponsor, creating incredible energy in our stores, interacting with our educators and ultimately reaching 4 million guests over the race weekend. In the Hamptons, in collaboration with SoulCycle at the Barn, we hosted guests throughout the summer. And just 2 weeks ago in Vancouver, we hosted our sixth annual SeaWheeze run and festival, arguably the best half marathon in the world, welcoming 10,000 runners from over 18 countries to experience the best of the brand and creating a positive halo impact on local store performance. Focusing now on product. Our Q2 performance in men's positively reflects the $1 billion-plus potential ahead of us in this category by 2020. Men's is still one of our best-kept secrets, and we're focused on guest acquisition and talking to men in unexpected ways, through curated and targeted experiences, community activation and colocated stores. We continue to deliver significant outperformance in the core category of men's pants and shorts, seeing 23% growth in Q2, driven by the strength of our ABC franchise. Tops also performed well this quarter with ongoing demand for our multiple Metal Vent styles, including Surge, where we delivered new innovation in the lightweight version, Henley and 1/2 Zip. Looking to Q3. I'm excited about our first focused men's brand campaign launching mid-September, expressing our unique perspective as an extension of This Is Yoga. Turning now to our women's business. Bottoms performed strongly, led by our Engineered Naked Sensation styles, Align and Fast & Free. Women's tops, both short sleeve and long sleeve, drove a really strong inflection in our comp as our guests responded positively to burnouts, engineered mesh and our supernatural fabrics, delivering the soft, natural feel guests love with high-performance attributes. As we enter the second half of the year, I'm excited to see the momentum continuing in Q3 across jackets and outerwear, specifically within the core scuba hoodie and packables. With a dedicated focus on this category for fall, our teams have created an assortment balancing function and fashion. Building on our core product offering, we launched an exclusive capsule collection with Taryn Toomey. Brought to life through a beautiful campaign, we had an overwhelming positive response with majority of online products selling out in the first day. On the theme of exploration, we continue to invest in delivering the most innovative, quality, functional items across our guest needs. Given our unique ability to connect with consumers, enabled by the strength of our educators, we can easily adapt to new strategies to cater to our guests' wants and needs. For example, this fall, we're piloting our first head-to-toe guest offering in select stores across North America through a partnership with APL, a footwear brand that shares our values, living at the intersection of function and fashion. This model of partnering and learning how to deliver the best experience possible to our guests provides great insights as we explore new categories in the future. Looking to Q3, we'll see the launch of our newest fabric innovation, Everlux, designed for high-intensity workouts like spin, where a studio environment provides little airflow and high humidity as Everlux wicks the wet sweat like nothing else. As I shared in my opening remarks, the initial response to our first global brand campaign has been positive and a great learning with an exceptionally strong connection in China as we look to accelerate how we amplify the reach and engagement of the brand. As we enter the fall, we're excited for you to see the next iteration of This Is Yoga brought to life in our men's and holiday campaigns. Before passing over to Stuart, I'd like to take a moment to share some updates to our Board of Directors and executive team. First, a very warm welcome to Tricia Patrick, who joins the board from Advent International, bringing global experience across consumer sector. I know she will bring valuable insight to all of us. I'd also like to say thank you to Steve Collins, who has stepped down from the board, for his commitment and valuable contribution during what has been such a tremendous period of growth and development for lululemon. Following 3 years with the brand, I want to share gratitude for Duke Stump, EVP of Brand & Community, who will be moving on at the end of September. We are grateful for his leadership and commitment to building purposeful, authentic brand storytelling, and a search is underway for a new leader. Our EVP of People & Culture, Gina Warren, will be leaving as well for personal reasons, and we have a great internal candidate stepping into the role. While these changes are important, we have a strong and expanding team driving this business as it continues to grow and evolve. The brand is stronger than any of us individually. And as this result powerfully demonstrates, we are firmly in control of our destiny and believe there is tremendous potential ahead of us. In closing, this has been a standout quarter as we made significant progress within our key growth drivers. I'm excited by the momentum in our business as we enter fall, driven by product innovation, community activations and key partnerships, which build loyalty with our new and existing guests alike. I'm energized by the enthusiasm and dedication I see every day from our global collective, and I'm grateful for their passion to grow our brand. I have full confidence that we can deliver on our 2020 vision and cement our position as the leading global brand that defines an active, mindful lifestyle.

Thank you, Laurent. As you mentioned, we are pleased with the acceleration in our business in Q2 and the positive momentum that's now continuing as we enter fall. The strength we saw in the second quarter was broad-based across all channels and reflected in our key operating metrics. Specifically, our store business saw a nice improvement in traffic that is now extending into the early part of Q3. We also saw positive trends in conversion, AUR and UPT, which gives us confidence in our store comp trends as we're not depending on any single factor. And online, while the business did benefit from our warehouse sale, the underlying KPIs are healthy as we've seen increases in both traffic and conversion as guests are responding nicely to the enhancements we're making to the site. And as Laurent also mentioned, we are still in the early innings of our e-commerce business and continue to see outsized growth potential here. I'm also excited for the ongoing strength we're delivering in product margin. Our adjusted gross margin increased 220 basis points in Q2, well above our expectations. As we continue to elevate our game and supply chain, we expect to deliver ongoing product margin benefits as well as new strategic capabilities on which I will elaborate shortly. Before taking you through our Q2 results, I'd like to update you on the evolution of our ivivva business. As of August 20, all the ivivva stores and other locations planned to close have ceased operation. 7 locations remain operating in key markets around the country. And our Fashion Island ivivva location has been closed temporarily but will reopen in the coming months. There's been no change to our e-commerce business, which remains in full operation. We continue to estimate that total costs associated with the transition will be $50 million to $60 million, which includes the $17.7 million realized in Q1 and $5.4 million recognized in Q2. The bulk of the remaining costs will be recognized in Q3. Now turning to the details of Q2. Total net revenue rose approximately 13% to $581 million with the increase in revenue resulting from strong performance across all parts of the business. In our store channel, we delivered a 2% comp store sales increase, reflecting an acceleration sequentially from Q1. And more impressive was the 30% comp we posted in e-commerce, reflecting the ongoing success of our efforts here. We did hold an online warehouse sale in the quarter, which added approximately 14 percentage points to the overall e-commerce comp. So on a combined basis, we delivered a 7% constant dollar comp increase. We also posted increased square footage of 11% versus last year, driven by the addition of 42 net new company-operated stores since Q2 of 2016: 24 net new stores in the U.S., 9 in Asia, 4 stores in Canada, 4 in Europe and 1 in Australia/New Zealand. And finally, the impact of foreign exchange decreased revenues by $2.4 million. Gross profit for the second quarter was just over $297 million or 51.2% of net revenue compared to 49.4% of net revenue in Q2 2016. The gross profit rate in Q2 was adversely impacted by 40 basis points related to the ivivva restructuring. Excluding these items, adjusted gross margin increased 220 basis points versus last year. This exceeded our expectations for the quarter with the primary driver being a 260 basis point increase in overall product margin, resulting from favorability in product mix and lower product cost, partly offset with higher markdowns due to the online warehouse sale. Offsetting these factors were 20 basis points related to foreign exchange and 20 basis points of deleverage in occupancy, depreciation and product and supply chain costs. SG&A expenses were just over $225 million or 38.8% of net revenue compared to 35% of net revenue for the same period last year. The deleverage in SG&A was generally in line with our expectations. Approximately 1/3 of the increase relates to the planned costs associated with the improvements to our e-commerce platform that we previously outlined. An additional 1/3 of the deleverage is due to costs associated with our global brand campaign, This Is Yoga, and related digital marketing. Foreign exchange contributed to the remainder of the deleverage as we anniversary-ed prior year gains. It is important to note that our FX revaluation exposure this quarter was largely mitigated due to the hedging strategies we had put in place earlier in the year. Separately, as a result of our transition of the ivivva business, we incurred $3.2 million in asset impairment and restructuring costs associated with the write-off of capital assets, lease exits and severance. Operating income for the quarter was approximately $69 million or 11.8% of net revenue compared to 14.4% of net revenue in Q2 2016. Excluding the pretax charges of $5.4 million related to the planned closures of the ivivva stores, adjusted operating income for the quarter increased to $74 million or 12.8% of net revenue versus 14.4% of sales last year. As a reminder, operating margin this quarter includes approximately 120 basis points of costs associated with enhancements to our e-commerce business as previously mentioned. Tax expense for the quarter was approximately $21 million or 29.9% of pretax earnings compared to an effective tax rate of 28.1% a year ago. The adjusted tax rate for the quarter was 29.6% compared to 30.5% in the second quarter of 2016. The tax rate came in lower than our guidance due to favorable adjustments related to our 2016 returns. Net income for the quarter was approximately $49 million or $0.36 per diluted share compared to earnings per diluted share of $0.39 for the second quarter of 2016. Net income in Q2 2017 included $4 million or $0.03 per share in ivivva-related charges. Excluding these charges, adjusted EPS was $0.39 per share compared to adjusted EPS of $0.38 last year. We repurchased 1.5 million shares during the quarter at an average price of $52.93 per share. By the end of the quarter, we had completed a total of $91.5 million in total share repurchases under the current $100 million authorization, putting our weighted average diluted shares outstanding at 136.3 million. Capital expenditures were $30 million for the quarter compared to approximately $45 million in the second quarter last year. The reduction relates primarily to lower corporate head office and IT capital versus the prior year. Turning to our balance sheet highlights. We ended the quarter with $721 million in cash and cash equivalents. Inventory at the end of the second quarter was $316 million or 14% higher than at the end of Q2 2016, in line with our forward sales outlook. We expect our inventory growth at the end of Q3 and for the balance of the year to generally grow in line with our forward sales trend. Turning now to our outlook for the third quarter and updated outlook for the fiscal year 2017. Please note that the guidance we are sharing excludes costs related to the ivivva restructuring. We are pleased with the momentum we are seeing in the business in all channels with exciting product launches, cohesive storytelling in stores and online, and an improving web experience, these factors are now carrying the momentum we saw in the second quarter into the third quarter. For Q3, we expect revenues to be in the range of $605 million to $615 million. This is based on a comparable sales percentage increase in the mid-single-digit range on a constant-dollar basis compared to the third quarter of 2016. This also assumes the Canadian dollar at $0.77 to the U.S. dollar and 14 new-store openings in the quarter. We anticipate gross margin normalized for ivivva to be relatively flat with Q3 of last year. The strong product margin improvement we've experienced over the last year while still improving in the third quarter will moderate as we are now anniversary-ing last year's significant increases. These increases are then offset with modest deleverage on occupancy and depreciation. We expect SG&A in the third quarter to deleverage from Q3 2016 by approximately 50 basis points. This deleverage is primarily associated with our continued efforts to deliver critical enhancements to our e-commerce website that are extending into the third quarter. Assuming a normalized tax rate of 30.4% and a 136.3 million diluted weighted average shares outstanding, we expect normalized diluted earnings per share in the third quarter to be in the range of $0.50 to $0.52 versus $0.50 a year ago. For the full year 2017, we expect revenue to be in the range of $2.545 billion to $2.595 billion. This is based on a comparable sales percentage increase in the low single-digit range on a constant-dollar basis. As we stated last quarter, the guidance range takes into account the closures of our ivivva stores and the associated reductions in revenues. We expect to open 47 company-operated stores in 2017. This includes 15 stores in our international markets and represents a normalized square footage increase in the low double digits. We expect normalized gross margin for the year to increase approximately 100 basis points from 2016, primarily driven by product margin improvements, offset with modest deleverage in product and supply chain SG&A as well as occupancy and depreciation. We expect SG&A for the full year to deleverage by approximately 50 to 100 basis points versus 2016. This includes the digital-related investments incurred this year, which accounts for approximately 50 basis points of the increase. In addition, we will continue to invest in brand and community activities; technology, which I will speak to a bit more later; and our international expansion. As indicated in our Q3 outlook, we continue to expect the SG&A rate to moderate, and we expect leverage in Q4. We now expect our normalized fiscal year 2017 diluted earnings per share to be in the range of $2.35 to $2.42. This reflects the Q2 upside, along with our continued confidence in our outlook for the second half of the year. Our EPS guidance is based on 136.3 million diluted weighted average shares outstanding and also assumes a normalized effective tax rate of 30.3%. We expect capital expenditures to range between $175 million to $180 million for the fiscal year 2017, reflecting new-store openings, renovations, relocation capital and also strategic IT investments. Before we take your questions, I'd like to highlight our ongoing efforts in both supply chain and technology as we build the infrastructure needed to support a $4 billion-plus organization. Looking at our supply chain. Over the last year, we've realized significant benefits to our product margin, thanks to the strategic initiative we began in 2015. That project led directly to reduced AUC and has contributed to over 350 basis points of product margin expansion in the last 12 months. While we're now anniversary-ing those improvements, I'm excited by the opportunities that remain for us to realize efficiencies within our supply chain and further improve our product margin. We currently have efforts underway that will allow us to dramatically improve our speed and flexibility in how we bring product to market. We're accomplishing this in several ways, including the development of a segmented supply chain to unlock efficiencies, staging fabric to better position us to chase demand and implementing new speed models for our core and seasonal styles. In addition, one of our key strategic sourcing partners is pursuing production facilities in Haiti. This would not only help us reduce lead times on product we source with them, but we would also realize freight and duty benefits as well. And turning to technology. We are focused on building capabilities that will leverage our business across critical areas and unlock new ways to engage our guests. In the near term, Julie Averill, our recently named CTO, continues to strengthen our technology team and set the IT agenda in support of our business goals. An important upcoming milestone will be the update to our website later in Q3, which will deliver site enhancements in time to impact the holiday selling period. We also continue to work to enhance our inventory allocation systems to improve how we flow product to better anticipate guest demand. Certainly more to follow but we're excited by the progress in these areas. And with that, let's open the call for questions.

Laurent, the Everlux pant, how does that fit into the matrix regarding Luon and Luxtreme? And as you think about product and the big opportunity buckets longer term, could you speak to the to and from opportunity within women's? And any other thoughts you have on where your portfolio particularly has big opportunities to grow over the long term? And Stuart, I just had a question about thinking about digital in terms of where you are versus the investments and how you're feeling about the mobile experience and the integration with stores? And also, some of the earlier issues we saw, it seems like a lot of those are resolved, would love your thoughts.

Thank you, Oliver. You raised many points. The Everlux fabric is an ideal fit for our Engineered Sensation line, especially in high-sweat studio environments. It continues the successful approach we've taken to meet our guests' needs, whether they're engaging in outdoor or indoor activities, from high to low sweat levels. We're committed to innovating within our Engineered Sensation franchise, and we are excited to build on the success of our Nulu and Nulux fabrics. From a men's perspective, we have a fantastic campaign coming with the ABC franchise that will be expanded. In Q2, we experienced a significant increase in sales for both men's and women's tops, with strong growth in the low 20s. We're very pleased with that. The launch of the Enlite Bra exemplifies our innovative edge, as it became our top-selling bra shortly after being introduced. This reinforces our role as a leader in this market, focused on innovation. Delivering value enables us to further enhance average unit retail. Looking ahead, we are eager about the new jackets and outerwear arriving soon. Our pilot program for footwear illustrates our stores' agility to adapt to new categories and highlights the brand's strength as we expand into diverse areas. We are very enthusiastic about the upcoming opportunities.

And Oliver, to answer your questions on digital, we've made great progress in the second quarter. As we look at how that's reflected in our KPIs, we're seeing a really strong improvement in conversion and traffic. Most evidently, as you shop the site, you can see the improvements we've made in visual merchandising, integrating photography with how the site operates, which has significantly enhanced the online guest experience. Regarding the integration with the stores, the main focus has been on enabling and unlocking the omnichannel aspects of our business model. Connecting inventory across different channels has been a key focus. From a mobile standpoint, we see considerable opportunity for improvement, which remains a priority in our broader digital strategy. Looking ahead to Q3 and the upcoming website upgrades, we anticipate additional visual merchandising enhancements that will allow guests to shop more effectively. We will create better outfitting options and present our franchises more powerfully. Moreover, the update will give our e-commerce team greater flexibility to implement quick changes, as the earlier version of the site has been limited in this regard. This new update will enable us to respond more effectively to what's successful on the website. There will also be some checkout improvements, with more substantial changes planned for later in the year. We're pleased with our progress, and it's reflected in our results. We look forward to providing further updates during the Q3 call.

This is Kate on for Brian. Stuart, I was just hoping you could talk a bit more about the supply chain and product margin opportunity, the work that you're doing there. Certainly understand that the product margin opportunity might moderate here into the back half as we lap some of last year's gains. But next year, how should we think about the opportunity and the timing of the supply chain work that you're doing rolling through? And also, if you could contextualize it versus the 350 basis point gain that you've seen over the last several months?

We're very pleased with how our teams have developed a disciplined process in design, merchandising, planning, sourcing, and logistics over the past couple of years. This effort has led to the improvements we've observed. As we've indicated, the significant improvement in gross margin has progressed as expected from the second half of 2016 into the first half of 2017. We're continuing to identify opportunities to enhance our product margin, not only by leveraging economies of scale as we grow in size but also through a targeted segmentation of our supply chain. By assessing how long products remain on our sales floor, we can source them more efficiently according to their lifespan within our offerings. Additionally, we are focused on developing new capabilities in our supply chain that emphasize speed and flexibility. The ability to strategically stage fabric allows us to respond to emerging demand, which presents important opportunities to capture additional sales while improving our margin. We're in a much better position to adopt proactive strategies in our supply chain, which wasn't feasible a couple of years ago. We're excited to see these new opportunities arise.

And Kate, this is Laurent. I would quickly like to mention that our emphasis on innovation also enables us to enhance our margins through Average Unit Retail. The Enlite Bra serves as an excellent example of this. When I consider our focus on accessories and outerwear, I see two categories with significant growth potential, driven by strong innovation and healthy margins. Thus, our innovation will increase Average Unit Retail, which in turn will lead to ongoing margin expansion.

Yes. Laurent, I was hoping that we could talk a little bit more on the footwear pilot. Longer term, how do you see footwear as an adjacent category that you can go into? And more specifically, I was wondering, how do you think about finding what right balance in footwear between fashion and technical, especially when the technical players and the existing players in the industry are highly consolidated with substantial scale for innovation?

Thank you. We view this pilot as a valuable learning opportunity. APL operates in a space similar to ours, where function meets fashion, making it a natural collaboration for us. We've gained insights on potentially adding footwear to our store assortment, and in the fourth quarter, we'll continue to experiment with an online selection. This is an adjacent category that interests us, but we don't rely on it to meet our 2020 goals. We're exploring various categories, some might involve products with a three-dimensional aspect, while others could relate to services or content. We're maintaining a curious approach. None of these categories are essential for achieving our vision of reaching $4 billion in revenue by 2020. We're eager to continue learning and will assess the potential of these categories and their connection to our current initiatives. More updates will come in early 2018.

I would like to follow up on your comment about a partner building a facility in Haiti and moving closer to the end market. Do you anticipate seeing more of this with your sourcing partners in the long term? Additionally, can you discuss the benefits of this and how it might improve relationships with those companies in a competitive local market?

Sure, Matt. The supplier we are referring to is one of our closest and most important partners. Our discussions with them around this matter have been ongoing for a while. The volumes we plan to place with them have influenced their decision to pursue this particular opportunity. The benefits are clear, including faster market access and cost structure advantages, which are strategically attractive. We are continuously exploring different options and regions to diversify our supplier base for optimal combinations. The regional advantage of having suppliers closer to our home market is quite appealing, and we will certainly look to pursue and enhance that wherever it makes sense.

Can you talk about your plans for physical and online warehouse sales that are built into your back half guidance? And also curious about who that customer is. Are you seeing a different customer respond to that online warehouse sale? And then just one clarification. Did you quantify how the performance of tops versus bottoms or for men's? If you could provide some color there.

Paul, let me begin by addressing your question about warehouse sales. The timing and decisions regarding those sales are primarily influenced by our inventory levels and our assessment of sell-through rates, allowing us to determine when it makes sense to proceed with such events. We do not view these sales as a means to drive revenue. As we consider our revenue projections for the latter half of the year, they do not rely on warehouse sales. We will continue to monitor our inventory and decide how, when, and if we will hold a sale in the second half. Physical warehouse sales require more lead time compared to online sales, and we aim to avoid encouraging our customers to wait for these events. Therefore, we don't want to create a predictable schedule for them. Whether we will conduct one or a mix of sales this coming half is uncertain; it's an option we may utilize to manage our inventory effectively. Regarding the customer base involved, it includes both our loyal customers and those who are more price-conscious. We are pleased with the strong interest we receive for both formats, which reflects the demand and the appeal of our brand. Since we do not hold these sales frequently, the responses tend to be quite enthusiastic when we do. Concerning your question about the performance of tops versus bottoms, we continue to observe robust sell-through for bottoms, with strong double-digit increases, particularly in the 20s for both women's and men's pants during the second quarter, extending into the third. While tops are also performing well, showing healthy high single-digit to low double-digit trends in both men's and women's categories in Q2 and into Q3. Thus, while the tops performance is not as strong, we are not dissatisfied with the trend.

Stuart, just what's not performing well?

That's a great question. We're really seeing our efforts yield positive results across our key areas: digital, men's, international, and North America. There's a significant opportunity ahead of us, especially in accessories and outerwear, where we're increasing our focus. Accessories represent a high-margin category with great potential, serving as a good entry point for newcomers to our brand. We're enthusiastic about expanding our offerings in bags, socks, and intimates, and I'm particularly excited about the work we can do in outerwear. Our Engineered Sensation concept is translating well into outerwear, which also offers high margins. While we’re pleased with our current assortment for jackets and outerwear this fall, there remains substantial upside for both men's and women's lines.

I wanted to ask about the DTC business and the performance relative to the low to mid-teens guidance you gave for Q2. Just wondering, was the warehouse sale much larger than anticipated? Or what were the factors that drove total DTC so far ahead of your plans? And then ex the sale, I think up 16% constant currency. Is that how we should be thinking about that heading into the back half of the year? Or would you perhaps anticipate some acceleration as the site enhancements and digital marketing initiatives gain some momentum?

Yes, I'm really pleased with the e-commerce trend we observed in the second quarter. The conversion rate, in particular, showed a nice recovery, which I believe is due to the digital acceleration work we've been discussing. The warehouse sale also exceeded our expectations, setting a record for the volume we achieved online. Looking into Q3 guidance, we are optimistic and aligning our expectations with the mid-single-digit growth, considering the current business trends that align with our Q2 e-commerce performance, excluding the warehouse sale. We anticipate benefits in the second half of the year from digital enhancements, especially as we complete our website upgrades, which should positively impact our e-commerce trends. We're still seeing advantages from our "This Is Yoga" initiative and are continuing our investment in digital marketing. Our product assortment is improving, especially in jackets and outerwear, which is an area of significant opportunity as we move further into the year. On the brand marketing side, we're launching a men’s campaign later this September that will coincide with the introduction of new styles in our ABC franchise, starting with the ABC slim pants, which are performing well. Overall, we see many opportunities for growth in the second half of the year, both in product offerings, brand marketing, and execution across channels. I'm genuinely excited about what lies ahead.

On your global store profile, how best to think about the pace of store openings in Asia, in Europe? Can you talk to some of the drivers of the improved productivity you've been seeing more recently? And just where do we stand on international profitability?

I don't necessarily think the number of stores is the right metric to focus on. We've had a successful experience during Unroll China, live streaming to 150,000 guests, which was highly impactful. Our performance on Tmall, showing a 175% increase year-over-year, is a significant opportunity for brand visibility. Our strategy of densifying in major cities like London, Beijing, Shanghai, and Tokyo is proving effective. The positive ripple effect in Tier 2 cities regarding social media and brand awareness is substantial. I was pleasantly surprised by the impact of This Is Yoga in China, where we achieved excellent brand recognition at a low acquisition cost. We're not rushing into store openings; instead, we aim to be vibrant in the Tier 1 communities where we are focusing on densification. We'll continue assessing our footprint similarly to our approach in the U.S., where we've seen flexibility in store formats, from local shops to our recent Fifth Avenue location. The goal is to strengthen our presence in Tier 1 cities and leverage that with a robust digital ecosystem. In Asia, we maintain a strong presence on Tmall and are partnering effectively with WeChat. Regarding growth, it's consistent with our previous statements, and we're enthusiastic about the strong momentum in Asia, even though growth is slightly slower in Europe. I noticed the differences in excitement between Paris and Munich over the summer, particularly in the number of studios and audience engagement. We are seeing 50% growth year-over-year in Europe, so it's definitely progressing, albeit more gradually. Currently, we are concentrating on China, which we expect to account for about 60% to 70% of the Asia Pacific market by 2020. There was also a second part to the question.

On profitability, we are currently seeing a nice acceleration in Asia. As we mentioned earlier, we anticipate that Asia will break even, including Australia, by the end of this year. However, it will take a bit longer for our European business to reach that same breakeven point, although we are optimistic about the progress there. Regarding the overall profitability of the international markets, we can provide more information about when they will collectively become profitable in the future.

Great. And then just one follow-up. With the competitive environment clearly amplified across the overall athletic space, you guys have definitely been an outlier. Any categories where you've found that you do need to be a little bit more promotional? And just what do you attribute your relative strength? I'm just curious on your overall take on the athletic backdrop and if you had been pulled into it in any way.

I believe we have a distinct and unique perspective. We were the pioneers of this market, and our focus is on innovation rather than just competing for market share. We're more than just a channel; we are a brand that originated this market. Our positioning as an originator brand is quite unique. We excel at creating human connections, offering great products, and solving athletes’ problems, engaging with our guests throughout the process. This engagement is truly unique and powerful. Consumers are being more intentional about their purchases and interactions with brands, which is a significant advantage for us. Regarding men, there is a strong global redefinition of masculinity, and we are well-positioned at the intersection of athleticism and mindfulness. It would be a mistake to view us merely as a channel, unlike many other brands. Our identity as a brand fosters loyalty. Our positioning is truly distinctive, and we are very satisfied with it. We do not feel pressure to be more promotional in any categories. In fact, our innovations continue to resonate strongly with our guests.

Stuart, just 2 margin questions for you. I think you said that in the second quarter, markdown was unfavorable, a slight offset to the product margin. Could you just give us a little more color on what the markdown pressure was in Q2? And then just based on the guide in the back half of the year, what's left in Q4. It looks like there's a pretty decent leverage opportunity that you're guiding to, 50 bps or more. Just kind of curious, Stuart, where is that coming from? Are there investments that are rolling off? Is there something in the P&L that we should keep in mind? And then how do we think about that sustainability in leverage as we get into next fiscal year?

Yes, certainly, Ike. Regarding the markdown question, in the second quarter, we had a very successful online warehouse sale that accounted for the significant increase in e-commerce markdowns. This was the primary reason for the elevated markdowns in that quarter. Otherwise, we maintained a healthy markdown performance in our regular channels, which is really tied to the warehouse sale. Looking ahead to the second half, we're pleased to see that our management efforts related to SG&A are paying off, which is evident in our outlook for both the third and fourth quarters. This involves completing some one-time investments associated with our digital acceleration in the third quarter, which will roll off into the fourth quarter, allowing us to fully benefit from our cost management initiatives. The fourth quarter is also our largest sales period, providing the best opportunity to leverage our fixed costs. We prioritize SG&A leverage as we plan for the coming years. Our long-term strategy aims to achieve moderate SG&A leverage as we target operating profit exceeding 20%. We believe the recovery in product margins and the associated gross margins are on track to meet that 20% EBIT margin. After reducing the impact of the one-time investments, we expect to see SG&A leverage that will enhance our gross margin and align with our goal of reaching that EBIT margin. This is an essential part of our strategy and long-term outlook. Thank you for your question.

Thanks for joining us, everyone. We look forward to speaking with you in about 3 months when we report our third quarter results. Thanks.